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May 9, 2014

World Economy Stabilizes in ‘Great Moderation 2.0’: JPMorgan

Barely five years after the worst financial turmoil and recession since the Great Depression, the U.S. and fellow advanced nations are showing a stability in output growth and hiring last witnessed in the two decades prior to the crisis, in an era dubbed the “Great Moderation.” The lull points to a worldwide economic expansion that will endure longer than most.

Volatility in growth among the main industrial countries is the lowest since 2007 and half that of the 20 years starting in 1987, according to Bloomberg calculations based on International Monetary Fund data. Investors also are becalmed, with a risk measure that uses options to forecast fluctuations in equities, currencies, commodities and bonds around the weakest level in almost seven years.

“That’s why I call it the Great Moderation 2.0,” said John Normand, head of foreign-exchange and international-rates strategy at JPMorgan Chase & Co. in London. “It looks, sounds and feels a whole lot like that last time we had reason to use that label.”

Such calm finally is providing a support for equities over bonds and giving companies and consumers long-sought clarity to spend. This doesn’t mean the scars from the slump have fully healed: Growth still is subpar, and there’s a threat investors will repeat the excessive risk-taking that turned past booms into busts.

GDP Growth

The IMF’s latest forecasts suggest output volatility in the Group of Seven nations will ease to 0.4% this year compared with almost 3% in 2010 and a 0.8% average in the two decades ending 2007, according to the Bloomberg calculations, which measure the standard deviation in gross-domestic-product growth over rolling four-year periods.

Variability in the growth of employment also has declined to 0.1% this year; it tripled to 1.7% in 2009, calculations for the labor market show.

Trading has chilled: Bank of America Corp.’s Market Risk Index closed at minus 1.14 on May 2, the lowest since June 2007. Fluctuations in the $5.3 trillion-a-day currency market also are the lowest in about seven years, according to JPMorgan’s Global FX Volatility Index.

“People are catching up to a return to a more normal environment in terms of market volatility and the economy,” said Dominic Wilson, chief markets economist at Goldman Sachs Group Inc. in New York.

New Reality

The lackluster markets reflect a “new macro-economic reality” in which persistent low interest rates and a focus on boosting employment are delivering greater economic certainty and spurring equities, Ian Harnett, managing director at Absolute Strategy Research Ltd., said in a report published today.

“For now, most of the traits that have typically ended such periods of low volatility -- excess leverage and extreme valuations between sectors, stocks and assets -- have yet to emerge,” he said.

Professors James Stock at Harvard University and Mark Watson at Princeton University are credited with coining the phrase “Great Moderation” in a 2002 paper titled “Has the Business Cycle Changed and Why?” They found “strong evidence of a decline” in the volatility of U.S. economic activity, attributing between 10 percent and 25 percent of the shift to the Federal Reserve’s crackdown on inflation.

Prophetically, they warned “the past 15 years could well be a hiatus before a return to more turbulent economic times.”

A decade later, Wilson’s team is citing old and new trends in explaining why the world is returning to the relative calm it enjoyed before the crisis of 2008, which took down Lehman Brothers Holdings Inc. and global demand.

The shift may reflect how monetary policy is better equipped than it was in the 1970s to stabilize growth and inflation. Economies also have evolved toward less demand-sensitive sectors, such as services, while even manufacturing is less of an economic yo-yo, thanks to efficiencies in supply chains and inventory management.

Stronger Regulation

Goldman Sachs sees another explanation: stronger regulation of bank and consumer debt following the crisis means economic growth will be less amplified by easier lending than before. In the euro area, for example, loans to companies and households shrank 2.2 percent in March from a year earlier, according to the European Central Bank.

The Great Moderation 2.0 still may not prove so great. For one thing, the market calm may not last out the year, given the business cycle will mature and inflation concerns may emerge, according to JPMorgan Chase’s Normand.

“As that risk unfolds, we should see higher market volatility,’ he said.

The depth of the recent slump also ‘‘certainly does reveal serious limitations of the concept of a Great Moderation,’’ Jason Furman, chairman of U.S. President Barack Obama’s Council of Economic Advisers, said in an April 10 speech in Washington.

Policy makers are better able to offset small shocks than they were in the 1970s and can protect expansions from them, he said. The test is whether officials can address ‘‘larger, lower-frequency’’ threats that impose greater economic pain when they hit, such as the Lehman Brothers failure.

Property Surge

The lack of volatility also could feed complacency among investors, pushing them as it did before to take on more risk, which later proves foolhardy for them and the economy. Financial-stability concerns already are building within central banks, with U.K. residential property, which is gaining in value by about 10 percent a year, as well as technology stocks and junk bonds in the U.S. among the assets drawing attention.

Peter Dixon, a global economist at Commerzbank AG in London, questions the existence of a fresh moderation. Inflation is below the targets of many central banks amid deflationary whispers in Europe; many economies remain smaller than they were in 2007; and it took until March for U.S. private-sector payrolls to add back all the jobs shed in the recession.

The latest lack of volatility also is occurring at a lower level of growth. The G-7 economies expanded 2.6 percent in the 1990s and 2.2 percent in the first half of the 2000s, according to IMF data. Since 2009, growth has averaged 1.9 percent.

‘Old Normal’

‘‘I can’t see a return to the Great Moderation any time soon,’’ Dixon said.

If the calm does hold, then investors should be wary of holding too many Treasury bonds as growth gains momentum, said Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York.

In what he calls an ‘‘old normal’’ scenario, interest rates would rise gradually along with the economy, encouraging investors to seek out risky assets such as equities. Dutta estimated in an April 21 report that the U.S. economy is 57 months into its expansion, implying another 38 months just to get back to the 95-month average upswing in the previous period of moderation.

The same outlook holds for the world economy, according to Joachim Fels, co-chief global economist at Morgan Stanley in London. Starting in 1970, he identifies six global expansions: 1970-1974, 1976-1979, 1983-1990, 1994-2000, 2002-2008 and since 2010. That’s an average of 5.8 years.

Fels says the current pickup will last because slow recoveries leave lots of room for hiring and investment to increase. Low inflation means monetary policy can stay easy, while the lack of a synchronized acceleration lowers the risk of a joint overheating.

‘‘This global expansion could become the longest in postwar history,’’ Fels said.

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